Macro Markets Podcast Episode 60: Post-FOMC & Post-Election Analysis and Outlook
Steve Brown, Chief Investment Officer for Fixed Income, joins Macro Markets to discuss portfolio strategy and our outlook following the U.S. election and the Fed’s most recent rate cut.
This transcript is computer-generated and may contain inaccuracies.
Jay Diamond: Hi everybody, and welcome to Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I'm Jay Diamond, head of Thought Leadership for Guggenheim Investments, and I'll be hosting today. Now let's look back at the last several days: Last Friday, we received an underwhelming jobs number likely affected by weather related anomalies. We had the election results, which sparked a very strong market reaction, and the Fed cut rates another 25 basis points, further easing the economy toward a soft landing. At the same time, even though consumer spending, corporate profits and job creation all appear healthy, the election results introduce more policy uncertainty and global unease. So it's been a busy week with its share of market volatility. But whatever the backdrop, investment managers have to stay fully invested. So here discuss how to approach this challenge is Steve Brown, Chief Investment Officer of Fixed Income at Guggenheim Investments. Steve, welcome back and thanks for taking the time to chat with us today.
Steve Brown: Thank you, Jay, pleasure to be here and thanks for having me.
Jay Diamond: Well, Steve, before we dive into the details about this last week and looking ahead at a very high level, how do you evaluate portfolio decision making in such an eventful time?
Steve Brown: Absolutely, Jay. I think it's important to have a balanced approach that considers both near-term market drivers as well as longer-term our view. Coming into this week was that while the outcome would certainly matter, the long run potential impacts will be somewhat constrained and will take time to play out. One of the biggest implications of this week was, frankly, just to get through it. Markets don't like uncertainty, and this was a major volatility clearing event. Now everyone, whether that's consumers, corporations, investors, can begin to position more for the future. So the market reaction for most asset classes, as you alluded to, was resoundingly positive this week, particularly for risk assets. And we expect this strong technical backdrop to last at least for the remainder of the year. But from there, it potentially gets a little bit more challenging.
Jay Diamond: Right now to get started, let's start with the Fed. As expected, the Fed lowered its policy rate by 25 basis points this week. How much further do you expect the fed to cut, and what are our estimates versus the market consensus?
Steve Brown: The 50 basis point cut in September and the 25 basis points we received this week, is a strong signal that the FOMC will be responsive to evolving conditions and, importantly, that they still view current policy as restrictive. From here, we expect a more moderate pace of easing. At this point, our base case is for one more cut this year in December, and for now up to four more in 2025, which would take rates into the mid 3s. The Fed, as they reiterated numerous times yesterday, will continue to be data dependent, but absent a major shift in trends in either inflation or employment, they are very clear and that they want to take policy closer to a neutral stance.
Jay Diamond: So how do you square up the fact that the Fed is cutting rates, and that the advanced estimate for third quarter GDP came in at 2.8 percent? Do you think the Fed is going to be able to achieve a soft landing, and what does that mean for bonds?
Steve Brown: It’s a good question, and I think it’s important first to remember why the Fed is reducing rates. You know, interest rates were taken to restrictive territory because inflation was well above target and the labor market was particularly strong. The Fed, as they've called it, is recalibrating policy to account for significantly lower inflation and their current view that the risks to their policy, 2 percent inflation and full employment is more skewed. And there’s risks to both sides. To answer your question on the economy, yes, our baseline view is for the soft landing and no recession. But with the continuation of some of the bifurcation themes we’ve been talking about around the year that impacts both consumers and corporations. In the aggregate, the consumer is healthy and more confident that service is manageable or net worth is rising and housing prices remain elevated. However, there are still some pockets of stress on consumers, and the polling data from the election certainly showed the collective toll of inflation on the population. On the labor market, the concentration of gains in employment to certain sectors, as our Macro Team has been highlighting, as well as the lower hiring rate, leave some downside risk to employment, as does future slowing immigration. So it's two-sided on the consumer. On the corporate side, you know, large and well-capitalized corporations continue to do very well. As we’re aware. Earnings and indices are at record highs, stocks are at record highs, and the regulatory picture is largely agreed to be more favorable for most industries, and conditions are now ripe for more M&A buybacks and capital investments as well. Banks will likely get less restrictive constraints and capital rules will change, and more broadly, financial conditions have eased. However, more debt-laden companies, including some small caps in sectors like commercial real estate, are still living through the impacts of higher interest rates and secular changes. So, like the consumer, in some ways there’s the haves and the have nots on the corporate side. So to your main point, what does this mean for fixed income? While spreads have continued to tighten, all-in yields remain relatively high. And starting yields are highly correlated with future performance. Diversified portfolios of high income generating investments can produce yields from 5–8 percent or even more, which in our opinion continues to be very favorable relative to post-GFC history and relative to other asset classes and investors are noticing, and we continue to see positive flows.
Jay Diamond: Let's do a quick post-election roundup: There's been a bit of a backup in rates. How high do you think yields can go from here?
Steve Brown: We still think we’re in an era of a trading range, so taking the 10-year yield as an example range of 3.5 to say 4.5 percent, now we flirted with the upper bounds of that range in the initial market reaction to the red sweep, and that may ultimately increase the upper bound of the range at the margin. But we think that we’ll continue to operate within that range. There is incrementally a little bit greater risk of higher yields, as I just said, post-election. But there’s in many ways a natural corrective mechanism in place, and that higher yields ultimately solve and are corrective for the issues that cause higher yields. And then they result in lower yields. So this range, which I think is the most important part, is that this provides an attractive floor for income in the future within fixed income and within credit more broadly. And as I stated earlier, your starting yield is highly predictive of your future returns. So a higher, more stable baseline level of yields is broadly positive for the asset class.
Jay Diamond: So given this backdrop, Steve, what have we done with regard to positioning in portfolios.
Steve Brown: We’re usually positioning most of our strategy around medium- or longer-term views, none of which substantively changed over the last couple of weeks. With regards to interest rates, we’ve been staying roughly neutral on duration with the steepening bias and underweight the long end. As mentioned, the event rest of the past week was likely to be concentrated further out the curve, and market reaction, I think, validated that. We’ve also been adding tips exposure in the last couple of weeks as yields backed up and breakeven stayed relatively behaved. There is an overarching consensus that this change in regime does add at least volatility risk around inflation. And so we think having some inflation protection within bonds is useful. Frankly, if we were to get outside of the range on the upper bound and likely continue to add longer duration instruments, because as I said earlier, there’s some self-correcting mechanism in place that ultimately, we think will lead to more stable yields. But importantly, rates are likely to remain volatile. This creates opportunity both in asset allocation shifts as well as in trading around the range and in monetizing some of that volatility, namely within Agency mortgages, which is a good way to capture that higher vol premia and allocate to an asset class that has underperformed most of the rest of fixed income.
Jay Diamond: Steve, does the election have any impact on the Fed path?
Steve Brown: The Fed, as we led off with, we think is on a path towards neutral policy. And so while, of course, the fiscal side of the house and other regulatory impacts or changes will influence the economy and inflation and employment. For now, we don’t think it materially changes the path for the Fed, and so the short-term interest rates should be moving into the 3s, potentially as early into the first half of next year. And then from there, there will be more discussion as to what the policy is once the Fed is a neutral.
Jay Diamond: Does the election play into evaluation and performance of risk assets?
Steve Brown: So the initial reaction from risk assets has been, as I said, resoundingly positive, you know, the deregulation theme. And as I said, the passing of the event risk was important and was the main driver of credit spread tightening and equity appreciation in the last couple of days on the vol-passing event, you know, a lot of participants were neutral on risk or had overlapping hedges on, and so adding exposure or moving these hedges, we think is also further provided a tailwind for moves and risk assets. And it’s really been across a lot of different categories, anything from equities to credit products to cryptocurrencies, you’ve seen a pretty strong rally for on the back half of this week.
Jay Diamond: Last question on the election, Steve. You said before that you're staying focused on the longer term, which is your perspective as an investor manager, but does the election change the longer term big picture for you?
Steve Brown: Yes and no. In the kind of what matters the most, it’s still a relatively benign economic environment in a positive sense, as we expect a continuation of the soft landing theme. That in and of itself means it’s usually a good environment for risk assets and credit, as that near-term recession risk continues to recede a bit. There are some, of course, policy implications, both positive and negative. And then, of course, there’s the narrative or talk and then what will ultimately be implemented. Deregulation more broadly we think is a positive impact, particularly for certain industries and sectors like banks and energy in the reshoring theme and kind of a more nationalist policy. But that with it can come some risks or negative impacts to other industries or more globally, you know, a ratcheting up of trade wars, geopolitical risk was on balance and negative and could offset some of that potential positive impulse. When it comes to things like tariffs, they will directly impact the inflation narrative and theme on a base case. They may be short-term inflationary, but then the policy reaction and kind of the impact on the markets will become a discussion on whether there's a price level change or something that’s more structurally embedded in inflation. And so those longer term impacts will have to be debated and considered for policy. So, in short, the importance of the passing of the event, having clarity on who is in charge and the potential latitude that there is for change in Washington will be fed into all of our calculus as we think about the future, with both positive and negative impacts.
Jay Diamond: Turning to some strategic questions for you, for investors who are waiting on the sidelines in cash, is it too late to come into the bond market now at the Fed has started easing?
Steve Brown: No, it’s not too late. In fact, easing cycle is usually very positive for fixed-income returns, and even relative to other asset classes, investors can still earn very attractive yields. As I mentioned, that baseline level of rates from that trading range plus some incremental credit spread, which is generally what we're doing in our strategies, provides a high level of income and the potential for price appreciation if spreads were to move tighter and or if rates were to decline. Most parts of the yield curve had this inverted over the past few months and the fed funds 10-year curve, which is the last remaining part that’s negative, should do so in the first half of next year as fed funds rate continues to decline. So that curve steepening trend should remain. And as short term rates fall, that will drive the yields on money markets and other short term instruments lower. So with that, we should have a more normally shaped upward sloping yield curve, which would again allow for higher incremental income and potential return by going a little bit further out the curve, which is what most fixed income strategies are doing. So absolutely it’s not too late.
Jay Diamond: So it’s not too late now, but there will come a point when it is too late?
Steve Brown: Although our expectation for the longer term is that fixed-income yields won’t get back to the lows that we saw, say, in 2020 or the immediate aftermath of the financial crisis. And that's both the expectation and I guess that hope, because the scenario where that did happen is largely meaningfully negative for probably a lot of other asset classes as well. So we do just expect a longer-term sustainable level of attractive yields for fixed income, which influences both the timing decision but also the long term asset allocation decision, both of which are generally positive.
Jay Diamond: Now we’ve observed that credit spreads have tightened over the past couple of months, how do you think about credit risk right now?
Steve Brown: That's a good point, and credit spreads are back close to their year day tights. But frankly, for the right reasons, those reasons are multifold. One credit fundamentals remain strong, especially for higher quality and larger issuers too. As I've said a few times, we’ve gone through some event risk in the last week, which has led to some unwinding of hedges and engrossing up of exposures, so that in and of itself led to further tightening and spreads. You could say another way that spreads were optically wider than they should have been had the event risks not been there. The technicals are very strong. This is a component that does not look like it's going to change soon as we look out. Over the past year or so, net new issuance has been very light, and a lot of asset classes and borrowers can be patient if they need to be. So issuance expectations for the remainder of the year remain muted, and that leads to a market dynamic where there’s frankly more demand than there is supply, which leads to lower spread volatility, tighter spreads in general, and then potentially capped upside with regards to spreads if markets were to start moving in the other direction. So really strong technicals and fundamentals, those are good reasons to take credit spreads.
Jay Diamond: So given everything we’ve discussed, have you been making any notable portfolio allocation changes that you'd like to go through? I mean where are you finding value now?
Steve Brown: When we look out over the past year, we’ve had a few major themes express, none of which have meaningfully changed recently, although there have been some tilts. One, the primary theme would be that income would drive performance, and essentially the more income you can generate while mitigating other risks, a better positioning. So we don't expect that theme to move away. I mean, that is the nature of fixed income and credit investing more broadly. And so finding investments out of indices or in small or other private parts of the markets is a good way to consistently do that, which is something that Guggenheim focuses on to credit spreads relative to fundamental risk are after we’ve gone through that, they’re relatively tight. But as I said, they’re kind of tight for the right reasons. But importantly, they’re not equally priced across sectors and issuers, meaning there’s value in making tilts within sectors and issuers. So on the sector side, we’ve prioritized things like securitized credit, which have been a large weighting, as have bank loans and other short duration higher income investments, private credit spreads, and strategies where that is an allocation continue to provide better compensation for risk than, say, the syndicated and or outlook markets. So we’ve wanted these tilts to drive and influence performance positively, and they have on the year prospectively. The longer rate volatility stays elevated, as I mentioned earlier, and the relationship to credit gets wider or likely to continue to further incorporate age, CMBS, and other strategies that can capitalize on that dynamic. As a sector, we’ve generally been underweight over the long run because it hasn’t warranted, from a relative attractiveness standpoint, much of an allocation that has shifted on the year and might continue to shift in the future. And then finally, uncertainty premium has been high and will likely remain high. So for us, that means not taking big positioning swings in one direction or another and being more defensively positioned and having some dry powder to allow for future flexibility if market conditions change. It's also a time for disciplined credit filters and a focus on bottom-up underwriting. The potential for industry or issuer dispersion to increase, it’s been very muted recently over the coming years, particularly given all the shifts that are going on that we’ve only briefly spoken about today. And when overlaying that with the fact that spreads, particularly in certain asset classes, are not terribly tight, so while we've been through some momentous events this year, now is not the time to let your guard down.
Jay Diamond: Steve, this has been terrific. Thank you so much for your time on a busy day. We’ve covered a lot of ground in our brief time together, so if I could ask you to summarize, what is the main takeaway you’d like to leave our listeners at the end of our conversation?
Steve Brown: Well, fixed income has been a laggard relative to other asset classes over the past 10 or so years, but now that we’re through the major reset in yields where we went, as we’ve discussed, from zero essentially to 5 percent, we’re now in this range, which is a much better range for investing. You can even just look over the last year, most fixed-income categories have returned 7–10 percent, and in some cases double digit returns. That's on a trailing one-year basis, which has meaningfully outperformed cash and at times provided a ballast to negative performance from risk assets like stocks, the typical attributes of a fixed income or credit allocation. So the prospects for returns from here remain bright. And frankly, continued volatility provides an opportunity for active management. I’d really just like to thank all our listeners for their continued partnership and engagement and wish you best of luck for the rest of the year.
Jay Diamond: Well, thanks again for your time, Steve. I hope you'll come again soon and visit with us and tell us what you're thinking.
Steve Brown: Thank you so much, Jay.
Jay Diamond: And thanks to all of you who have joined us for our podcast today. If you like what you are hearing, please rate us five stars. Now if you have any questions for Steve or any of our other podcast guests, please send them to Macro Markets at Guggenheim investments.com and we will do our best to answer them on a future episode or offline. I’m Jay Diamond and we look forward to gathering again for the next episode of Macro Markets. In the meantime, for more of our thought leadership, please visit Guggenheim investments.com/perspectives. So long.
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Investing involves risks, including the possible loss of principal. Stock markets can be volatile. Investments in securities of small and medium capitalization companies may involve greater risk of loss and more abrupt fluctuations in market price than investments in larger companies. The market value of fixed-income securities will change in response to interest rate changes in market conditions, among other things, investments in fixed-income instruments are subject to the possibility that interest rates could rise, causing their value to decline.
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